Yes, ADRs Do Carry Foreign Currency Risks

 

August 25, 2017 [currency risk, hedging, rate exchange, ADRs]
Todd Wax, CFA


Prices of American depositary receipts reflect both a foreign firm’s locally traded share price and the exchange rate movements of its home country’s currency against the dollar.

 

A common misperception is that American depositary receipts, which bundle ordinary shares of an overseas-listed company into a U.S.-traded security, don’t carry currency risk. Driving the confusion is the fact that ADRs, as they are commonly known, are traded in U.S. dollars. While ADRs effectively spare U.S. investors the administrative expense and foreign tax assessments associated with trading in foreign-listed stocks, they don’t nullify the impact of currency exchange rate fluctuations.

The price of an ADR is affected by the movements of both the company’s local share price and the national currency rate of exchange against the U.S. dollar. The same is true of a U.S. mutual fund that invests internationally, as it is priced in U.S. dollars but most often holds local currency-denominated ordinary shares of foreign companies. Obviously, the mutual fund will be influenced by foreign currency movements as they translate back into U.S. dollars. It’s similar with an ADR, which reflects both the local share return and currency effect.

Part of the diversification benefit of investing internationally is foreign currency risk. Of course, such risk can help or hurt overall returns for U.S. investors, depending on the degree to which it is hedged with currency forwards. So far this year, the U.S. dollar has broadly weakened against foreign developed and emerging market currencies. Hence, unhedged U.S. international, emerging market and global portfolios have benefited from the gains of overseas currencies against the U.S. dollar. Those that have hedged their currency exposures have seen a drag from those hedges, though in the case of major currencies, the costs of hedging are low, determined as they are by prevailing benchmark interest rates.

Beyond the costs associated with currency hedging, savvy investors in overseas securities will consider a number of other factors, including corporate fundamentals such as the currencies in which the bulk of a company’s costs and revenues are denominated. Moreover, a foreign multinational company may also hedge its own currency risk exposures. At the macroeconomic level, benchmark interest rate differentials between the U.S. and the home country, along with trends in the country’s balance of payments, clearly matter for the outlook of the currency’s exchange rate.

Over time, partial and dynamic hedging can reduce portfolio volatility of U.S. mutual funds focused on overseas investing. By the same token, currency effects in ADR returns may be a wash over the long run. 

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